Summary of Risk Alert on Wrap Fee Accounts

Author:  Greg Reymann

Recently the SEC’s Division of Examinations (the “DOE” or the ”Staff” ) published a Risk Alert covering wrap fee program sponsored or offered by investment advisers. Wrap fee programs require advisory clients to pay a consolidated fee for investment service and other costs, including commissions, trading fees and administrative costs. As noted in the Risk Alert, the Division focused on wrap fee programs given the continued growth of investor assets participating in these programs. 

The Focus

According to the DOE, over 100 examinations of advisers associated with wrap fee programs were conducted, including advisers that served as a portfolio manager in, or a sponsor of, the wrap fee program, and advisers that used unaffiliated third-party wrap fee programs. 

As expected, the Staff reviewed whether advisers had fulfilled their fiduciary duty by having a reasonable basis to believe wrap fee programs were in the best interest of their client – both initially and on-going.  The Staff also looked into whether there were undisclosed transaction charges. 

The Staff also assessed whether advisers provided full and fair disclosures of all material facts to their clients, such as fees, expenses, conflicts of interests, and the entities involved. Lastly, the staff assessed the effectiveness of the adviser’s compliance and procedures.

Staff Observations

The first observation was that advisers generally did not adequately monitor the trading activity in clients’ accounts. Noted as the most common issue was the adviser’s failure to monitor trading away and the additional costs of such trading away practices. 

As suspected, the Staff also noted that, while initially okay, some advisers did not have a reasonable basis to believe that the wrap fee program were in the client’s best interest on an on-going basis. Thus, continuous assessments should be taken to ensure it is reasonable for the adviser to offer the wrap fee program to its clients. 

The Staff also noticed that disclosures were often inconsistent. Examples include variance in describing the wrap fee programs and its fees in the firm brochure, the wrap fee program brochure, advisory agreement and other wrap fee documents. The Staff also stated that many advisers had not adopted compliance policies and procedures that require initial and on-going reviews of wrap fee programs.  

Recommendations

Based on what the DOE observed, the following recommendations were made: 

1. Best Interest Reviews. Review of wrap fee programs should be conducted to assess whether the programs recommended to client are in their best interest, based on their financial situation, risk tolerances and investment objectives. This review needs to take place initially, and on an on-going basis to ensure that the program is in the client’s best interest. The on-going review should take place during the annual account or client review. 

2. Update Client Financial Situation. Periodically remind clients after conducting a best interest review to report any changes to their personal situations. 

3. Disclosure on Conflicts of Interest. Provide the client with disclosure regarding the advisers’ conflicts of interest related to transaction executed within the wrap fee programs. 

4. Wrap Fee Program Disclosure. Provide clear disclosure when recommending a wrap fee program, regarding services and expenses that are not included in the wrap fee. 

5. Adequate Policies and Procedures. Compliance policies and procedures of the adviser should include factors to be used when assessing whether investment recommendations favoring a wrap account is in the best interest of the client, and continues to be in his or her best interest on an on-going basis.  These procedures should also monitor how the adviser is seeking best execution on client transactions. 

Summary

In many ways, this is a low-hanging fruit. The SEC, as they demonstrated with mutual fund share classes, will always assume that the lower cost option that provides the same services as other higher cost options to be the fiduciary choice.  Despite this, there are many practical reasons to use wrap fee accounts – clients don’t necessarily want to be “nickeled and dimed” and often prefer the certainty of the wrap fee cost for convenience reasons.  

Notwithstanding the reasons that favor a wrap fee program, the SEC has made it clear that this is an area that will be examined, and therefore it is prudent to develop a process that requires a best interest review at the initial set-up of the wrap fee program and thereafter on an on-going basis. In addition, advisers need to disclose the fees and costs of the program, the adviser conflicts on recommending the program, and document its processes in a well written and fully descriptive compliance manual. Please contact us at 813-497-1400 if you have any questions regarding this Risk Alert and how you can mitigate any compliance issue associated with your wrap fee accounts. 

This article does not in any way create an attorney-client relationship. This article should not be seen as legal advice. You should consult with an attorney before you rely on this information.